Overview
Mixed data makes life difficult for Fed
Asset prices’ dependency on central banks has intensified this year despite the consensus view that monetary policy stimulus alone cannot rekindle real economic growth. And there is growing clamour for the Fed to ease policy further. But the data picture is mixed. The global manufacturing recession meme is gathering momentum amid gloomy US ISM data and persistent weakness in early cycle export-driven economies; an appreciating dollar has put further pressure on export-sensitive sectors and emerging markets.
The US consumer, however, remains resilient, although healthy data prints here should not be taken for granted as they tend to be lagging indicators. If the dual trends of employment growth and falling underemployment crack before the end of 2019, investors should expect a much greater focus on balance sheet capacity.
Bull steepener likely to benefit BB credits
The likelihood remains therefore that the Fed will ease policy further and resume balance sheet growth. This in turn may trigger the first-order response of a bull steepening in the US treasury yield curve - characterised by interest rates falling faster at the short end of the curve than the long end and resulting in a steeper curve.
Business sectors and asset prices that benefit from lower intermediate term rates should rally in this environment. For high yield investors, a quality bias means BB credits should continue to lead the asset class despite having healthily outperformed lower rated bonds so far this year. One important factor not to be overlooked for BBs, however, is the likelihood of increased supply through ‘fallen angels’, particularly from BBB credits in cyclical industries, which face losing their investment grade rating and being downgraded to junk status due to increased default risk.
In asymmetric risk asset classes like high yield, loss avoidance remains the key to providing healthy long-term returns. It is important to be selective even if we see an initial rally. Historically, when the Fed embarks upon aggressive easing to offset economic contraction, the economic tides have already begun to ebb. Monetary policy operates with a lag, further compromising liquidity and even solvency for very highly levered and growth-dependent companies. The ensuing growth retrenchment often requires more time than many of these issuers can endure, leading to more defaults.
Prepare for spread decompression and rising dispersion
Rising defaults are a natural and even desirable outcome at the end of a business cycle. They restore discipline and remove overhangs associated with the misallocation of capital that often occurs during episodes of abundant liquidity, boisterous animal spirits and heightened moral hazard. For investors this means they should prepare for wider and more variable spreads. Markets have already become more discriminating in separating the weak from the herd, but the process will have further to go if a recession is just around the corner.
There are at least two silver linings in these clouds. Firstly, widening spreads create a bigger cushion against default for investors since price moves in credit markets can often be indiscriminate, creating investment opportunities. Simply put, better entry points increase the odds of producing excess returns over the medium term. Secondly, Fed capitulation towards looser policy is likely to stabilise - perhaps even exert gentle downward pressure on - the US dollar, providing a natural relief valve for exporters and emerging market economies.
Conclusion
Highly valued asset classes such as US and EU BBs and sectors such as US gaming, media and consumer non-cyclicals can and will continue to get richer until we see spreads widening. However, in our view, once the cycle has turned, the lower quality options such as B credits will eventually offer investors better risk-adjusted returns. Until then, investors may need to be patient, taking advantage of any bull steepening that occurs, but keeping one eye on the next stage of the cycle.
